A huge increase in the amounts borrowed by already-indebted households in Britain and the US to buy new vehicles is fuelling fears that “sub-prime cars” could spark the next financial crash.
British households borrowed a record £31.6bn in 2016 to buy cars, up 12% on the year before, said the Finance and Leasing Association on Friday. Nine out of ten private car buyers are now using personal contract plans (PCPs) that have boomed since interest rates fell to historic lows.
Under these cheap leasing deals, buyers pay a small deposit and then guarantee a monthly payment for the next three years with the option to buy or hand back the car at the end. The rise of PCPs helps explain rocketing car sales in Britain despite flat or falling household incomes. A record number of new cars were sold in Britain last year – 2.7m – the fifth straight year of rising sales. Per head of population, the British are now buying more new cars than any major country in Europe.
Car financing in the UK is a “flashing light”, according to Andrew Evans, a fund manager at investment firm Schroders. “Borrowing is a very bad idea when it is done against a depreciating asset … such as a car,” adding that there is a “serious level of fragility built into the system”.
In the United States, debt-addicted Americans are also binge-buying autos. Last year the total stock of outstanding auto loans in the USA jumped to $1.1tn (£880bn), prompting one financial commentator, Harry Dent, to ask “Could cars be the death of us this time round?”
In late November the New York Federal Reserve bank warned that sub-prime car loan delinquencies were a “significant concern” as it said that auto loans were being taken out at a faster rate than any time in its history.
The borrowing boom is being driven by websites that have sprung up to take advantage of (for now) ultra-low interest rates. The most popular one in Britain is LingsCars, complete with eccentric design featuring a cat sporting a Chinese Communist party helmet.
But it has made Ling Valentine, who describes herself as the “Dragons’ Den car leasing queen” following an appearance on the BBC programme, Britain’s biggest individual seller of cars. She shifted £85m-worth last year, promising brand-new Ford Fiestas for just £150 a month. Everything is sold using leasing deals.
These lease deals are part a colossal build-up of overall debt in the UK, some of it taken out by people with poor credit scores, and which has some experts warning of an uncomfortable parallel with sub-prime mortgages before the great crash.
Last month the Bank of England warned that consumer credit, including car loans, is close to levels not seen since the 2008 financial crash. Credit agency Experian, which monitors personal indebtedness, told the Guardian that “the number of PCPs overall has increased five-fold (394%) over the last five years.”
Some of the car leasing loans in both the US and UK have been packaged into asset backed securities, an asset class that played a ruinous role in the credit crunch, to be sold on to investors. The ratings giants, Standard & Poor’s and Moody’s, have given most of these batches of loans a triple-A safety rating.
Multiple banks will be involved in any “auto loan ABS” (asset backed security). For example, a £1.3bn securitised package of UK loans issued by PSA Finance, an arm of Peugeot cars, included HSBC, Lloyds, San Francisco-based Wells Fargo and France’s BNP Paribas.
When residential mortgage-backed securities collapsed in 2007-08, there was a domino effect through financial institutions across the globe.
Should an auto ABS collapse, it is likely that the pain will fall mostly on the car manufacturers who stand behind their multibillion-pound leasing arms. At the Bank of England, economists on its blog entitled “car finance – is the industry speeding?” concluded that “the industry’s growing reliance on PCP has made it more vulnerable to macroeconomic downturns”.
It warned that “the manufacturer would be exposed [to] the impaired value of rented and leased vehicles returned at the end of their contracts should the balloon payments exceed the vehicles’ market values”.
One of the chief worries about the PCP market is that a glut of vehicles coming on to the used car market will depress values, pushing them below the expected sale value of the leased car after three years. Cars will be handed back to the manufacturers, potentially inflicting large losses on them.
Another worry is “delinquencies”, which refer to falling into default or arrears on a loan. If the economy tanks, as either interest rates, unemployment or inflation rises, then the ability of millions of people to keep up their loan repayments will fall, and impairments will balloon.
But at the FLA the head of motor finance, Adrian Dally, is sanguine. He said car loans in Britain are a small fraction of the £1tn in mortgage debt. In the US, that $1.1tn in car loan debt compares to more than $14tn in home mortgages.
Dally said lending in Britain has been highly disciplined, with little evidence of loans to sub-prime borrowers, and that “the UK is absolutely a world leader in the quality of underwriting and minimising risk”. The evidence for that comes from defaults and impairments, which are extremely low. In the Peugeot loans book, for example, the delinquency rate is just 0.08%.
Standard & Poor’s said it stress-tests the loan portfolios, building in scenarios such as a 45% fall in used car values, and even if that happened these securitised entities would remain viable. It said that across the UK and Europe, impairments on car loans are running at just 0.2%. It added that the “tenure” of the loan is typically just three years, not the 25-40 years common for mortgages. The debt mountain is whittled down within a handful of years, not decades.
Financial regulators have learnt from the sub-prime crisis, and are relaxed with the car lending market, said Dally, himself a former regulator. “As you can imagine, the Bank of England is all over this with a fine toothcomb.”